Distinguishing Between Direct and Derivative Shareholder Actions in California

By Gerald P. (“Jerry”) Burleson, Member of the California Bar, and Robert Kaufman, Senior Law Student, University of San Diego School of Law

In California, depending upon the relevant facts presented, a shareholder seeking redress against the corporation is required to pursue one of two distinct types of remedial actions. The first type of action, a “direct” action by the shareholder against the corporation, is a lawsuit to enforce a right against the corporation which the shareholder possesses as an individual. Bader v. Anderson (2009) 179 Cal.App.4th 775, 793. Examples of direct shareholder actions include suits brought to compel the declaration of a dividend, the payment of a mandatory dividend, or to enforce shareholder voting rights. Schuster v. Gardner (2005) 127 Cal.App.4th 305, 313.

The second type of remedial action against the corporation that may be available to a shareholder, a “derivative” action, is a suit by a shareholder to redress an injury to the corporation that the corporation has failed to pursue on its own behalf. Desaigoudar v. Meyercord, 108 Cal.App.4th (2003) 173, 183. An action is “derivative” if the gravamen, i.e. the “gist” of the complaint is injury to the corporation. Therefore, the right of the shareholder to bring the lawsuit derives from the primary right of the corporation to redress the wrong against itself, although its board of directors has failed to pursue the action. Id. The corporation is named as a nominal defendant in such a case on the ground that its consent to bring the lawsuit could not be obtained. Grosset v. Wenaas, 42 Cal.4th (2008) 1100, 1108. The alleged wrongdoers are also named as defendants in such a derivative lawsuit.

Under California law, a shareholder cannot bring a direct action for damages against the officers or directors under the theory that their alleged wrongdoing decreased the value of his or her stock. The corporation itself must bring such an action, or a derivative suit may be brought on the corporation’s behalf. Schuster at 312. Other examples of derivative suits are shareholder suits to recover damages for breaches of a fiduciary duty by officers or directors where the harm done was to the corporation itself, or suits to prevent an action by the board that shareholders feel would harm the corporation. Id. at 313.

The distinction between derivative and direct actions was central in the court’s decision in Bader v. Anderson. In its decision in that case, the court held that the shareholder failed to establish facts supporting a direct suit and also failed to meet the standing requirements of a derivative suit, and therefore the shareholder was unable to proceed in her lawsuit. To have standing to bring a derivative suit, the shareholder must either make a presuit demand upon the board to redress the injury, or the shareholder must show that such a demand on the board would be futile because the particular directors could not be expected to fairly evaluate the claims of the shareholder. Bader at 790. This demand requirement in shareholder derivative lawsuits is designed to encourage resolution of disputes within the corporation and “to protect the managerial freedom of those to whom the responsibility of running the business is delegated.” Id. at 789-90.

One reason for differentiating these two types of shareholder actions against the corporation is a fundamental aspect of corporate law that corporations are separate legal entities distinct from the shareholders. While shareholders own the corporation, the board of directors manages and oversees the business and affairs of the corporation. As part of its management power, the board has authority “to commence, defend, and control actions on behalf of the corporation.” Grosset at 1108. As the California Supreme Court stated in Grosset, “[b]ecause a corporation exists as a separate legal entity, the shareholders have no direct cause of action or right of recovery against those who have harmed it.” Id. at 1108. However, if the board of directors fails or refuses to redress an injury, the shareholders may then bring a derivative suit in the corporation’s interest to enforce the corporation’s rights and to redress its injuries. Id.

One way to recognize the difference between direct and derivative shareholder actions is to ask who suffered the alleged harm, the corporation or the shareholder individually, and who would receive the benefit of the remedy sought by the lawsuit? If it is a direct action, the shareholder will be required to show that the injury was to some but not all of the shareholders and is independent of any alleged injury to the corporation. In other words, the shareholder must demonstrate that the duty breached was owed to the shareholder, or to some of the shareholders, and that she can prevail without showing an injury to the corporation. New York City Employees’ Retirement System v. Jobs (9th Cir. 2010) 593 F.3d 1018, 1022. If the cause of action is not individual to the shareholder but is for injury to the corporation, the shareholder wishing to bring suit must bring a derivative action and must comply with the presuit demand requirements in order to have standing to bring suit.